Quantifying the Value of an Excellent Financial Advisor

For any business relationship to work, the value gained for both parties must exceed the cost. The calculation for a financial advisor is quite simple: The relationship works for the advisor if the compensation received in return for advice and service is enough to cover costs and a reasonable profit. The calculus for clients, when choosing a personal financial advisor, is more difficult. The relevant questions to ask are these: • Am I working with a typical or an excellent advisor? • What are the characteristics of a typical versus an excellent advisor? • How much does an excellent advisor benefit me over a typical advisor? • Is the value obtained from an excellent advisor greater than what I pay? Excellent advisors are not born; they are made through long years of education and experience. Unfavorable employment arrangements, lack of experience and judgment, and a need to collect short-term revenue can all be impediments to a young advisor becoming an excellent advisor. When choosing a financial advisor, I believe it goes without saying that clients should never settle for the typical. But for most investors, the difference between a typical and excellent advisor is difficult to see. In this post, I will attempt to illustrate what excellent advice looks like, and why excellent advice is so critical to your success as an investor. To begin, here is my take on the characteristics of each:

Typical Vs. Excellent Advisors

Excellent advice, as compared to typical advice, normally adds many hundreds of thousands of dollars to the total wealth of investors over an investing lifetime. However, this is not always the case – especially for low net-worth investors, those who have very simple situations, and those who do not follow advice. Typical advice, though, may not be beneficial at all; after the costs and conflicts of interest, an investor may be just as successful on their own. The advantages of excellent advice withinaccounts accrue automatically to clients, and the benefits are realized on an ongoing basis. Below I identify the various components of investment methodology common to excellent advisors, and express the advantage over typical advice of each component as an estimated annual percentage difference.[1]

Excellent Advice benefiting clients within accounts

Expense Ratios annual advantage: .24%

Every dollar paid in expense ratios is a dollar less of potential return for investors. If higher expense ratios equated to higher net returns, excellent advisors would use higher cost funds, but in reality the exact opposite is true: higher cost funds have lower net returns on average. Therefore the excellent advisor’s fund selections are low in cost, with an aggregate expense ratio for pragmatic[2] stock funds at .43%, and for passive bond funds at .13%. A blended account with 60% in stock, and 40% in bond funds[3], therefore carries an overall expense ratio of .31%.[4] According to Vanguard’s research, the average investor pays .61% in equity funds and .47% in bond funds. The average investor’s blended account, which is 60% in stock, and 40% in bond funds, therefore carries a blended expense ratio of .55%. The investor working with an excellent advisor with this blend between stock and bond funds saves on average .24% per year in expense ratios. It should be mentioned that the difference can be quite a bit more than that. Quite often an investor will have expense ratios in excess of 1.5% per year, with the difference being greater than 1% per year.

Rebalancing annual advantage .31%

The main determinate of risk and expected return in an account is the selected equity exposure percentage. Over time an account will drift away from the selected equity percentage. The goal of a rebalancing strategy is to control risk. An investor who wishes to maximize return without regard for risk would be well served with an account that is 100% invested into stocks; however, such an account will experience extreme volatility, and is more likely to be liquidated at a market bottom due to the high level of emotional distress suffered by investors. A blended account that is never rebalanced will likely eventually see increasing equity exposure and increased risk as well. According to Vanguard’s calculations based upon data from Thompson Reuters Datastream, over the past 53-year timeframe[5], a 60% stock/40% bond portfolio that was not rebalanced returned an annually compounded 9.36% per year with a risk measure of 14.15%.[6] A rebalanced 80% stock/20% bond account returned a higher return of 9.71% with nearly identical risk of 14.19%. Therefore, the rebalanced 80% stock/20% bond account captured the extra .31% without additional risk. The advantage of rebalancing is on the order of .31% per year.

Turnover annual advantage .58%

Turnover results in costs known as “transactions charges,” which take the form of of loads, ticket charges, spreads, and market push (equities only). Some loads, such as up-front commissions, are obvious to clients, as are ticket charges. However, the remaining charges are hidden to all but the most astute investors. For our purposes I will ignore the commissions earned by typical advisors. I will also ignore transactions costs within bond funds, as much of the turnover in these funds is due to bonds maturing ­­– a situation that does not result in costs, due to spread, which is the main component of transactions charges. The formula for determining transactions costs as a result of turnover is meant to be a rough estimate. John Bogle estimated transactions costs in large-cap equity funds to be 1.2 times the turnover rate.[7] The average turnover rate among domestic equity funds is unclear: Fool.com lists the average at 85%; Kiplinger at 100%, and Morningstar’s William Hardy lists it at 130%. We will be kind to typical advisors, and use the 85% average turnover rate. The excellent advisor’s pragmatic stock fund’s turnover rate is an exceptionally low 4%; which is even lower than that of many index funds. A comparison shows that the average predictive stock fund carries annual transactions costs of 1.02%, while with pragmatic funds they amount to .05%. The cost advantage here in the stock funds is .97%, and in the 60% stock/40% bond portfolio the advantage is .58%. Note that this advantage is understated for taxable accounts. High-turnover funds in taxable accounts create short-term capital gains, which are taxed at the higher “ordinary” income tax bracket, and they cause taxes to be paid sooner than otherwise. As this advantage varies by tax bracket, I will ignore it for purposes of measuring the advantage.

Cash Drag is an opportunity cost that is valid when comparisons are being made. It refers to the lost return in stock funds due to low returns on cash holdings verses the higher long run return on equities. Typical advisors and do-it-yourself investors as a whole are emotional, and they move money in and out of stock funds based upon short term events and ever-changing market outlooks. Investors become euphoric in bull markets, and run for cover in bear markets. This frequent change in sentiment results in deposits and withdrawals from stock funds. The mutual fund manager who is the recipient of deposits is awash in cash until the funds can be invested, and must keep cash on hand to meet withdrawals in bear markets. Often he or she is forced to sell equities at the worst possible time to meet the demands of shareholders. Pragmatic funds limit their relationships to large institutional investors and advisory firms that have demonstrated investment discipline. This allows them to hold smaller cash weights within their stock funds. The average cash weighting in predictive stock mutual funds as of May 2013 was 3.8%.[8] In the pragmatic funds, the average cash weighting is .4%. When the difference of 3.4% earns equity returns instead of cash returns, the advantage for a 60% stock/40% bond portfolio is .12%.[9]

Pragmatic Investing annual advantage 1.40%

Pragmatic Investing refers to the philosophy which rejects both active and passive management, and instead purposefully builds portfolios by taking advantage of the dimensions of expected return as outlined in the work of Eugene Fama and Kenneth French, including the value, size, and profitability premiums.[10] Since 1928, the annually compounded return of the total US Stock market has been 9.1%. The annually compounded return on the Dimensional US Adjusted Market Index which includes tilts toward these dimensions has been 11.7%.[11] A 60% stock/40% bond portfolio that has 90% of its equities in funds that exploit these dimensions of return will give advantage to the client of 1.40%.

The differences between the return in the funds themselves and the actual returns earned by investors in those funds can be explained by cash flows, which tend to be attracted by, rather than to precede, higher returns. In other words, on balance investors are buying high and selling low. With a few unhappy exceptions, the clients of an excellent advisor stay fully invested regardless of market movement. As a result, clients on average obtain personal returns that are very close to the returns of the mutual fund in which they invest. The annual advantage varies by size of fund, but the estimate of the advantage is 1.49% per year.[12]

Asset Location annual advantage: 0% to .75%

A well-diversified portfolio contains some securities that are less tax efficient than others. For example, Real Estate Investment Trusts, Precious Metals ETFs, Treasury Inflation Protected Securities, Corporate Bonds and High Yield Bond funds are not tax-efficient. They produce income that is taxable at the high “ordinary” income tax rates. In contrast, tax-free municipal bonds, tax-advantaged stock funds, and some single issue stocks are tax efficient: they produce little in the way of “ordinary” income; and more that is taxed in the lower long-term capital gains rate, which is deferred until the time of sale. Tax-qualified plans such as 401ks and traditional IRAs do not pay tax on income; only withdrawals are taxed. Therefore, an advantage can be gained by locating the tax-inefficient securities within these tax-qualified accounts. This allows us to locate the tax-efficient securities where it matters: within the taxable accounts. For example, assume a client couple who has a joint account and an IRA account. Further, assume the portfolio contains the following types of securities:

Domestic Stock Fund

International Stock Fund

Emerging Markets Stock Fund

REIT Fund

Precious Metals ETF

High Yield Corporate Bond fund

Long Maturity Corporate Bonds

GNMA pass through securities

Treasury Inflation Protected Securities

An advisor who utilizes proper asset location would place the holdings as follows:

Joint Account

Traditional and Roth IRAs

Domestic Stock Fund

REIT fund

International Stock Fund

Precious Metals ETF

Emerging Markets Fund

High Yield Corporate Bond fund

Long Maturity Corporate Bonds

GNMA mortgage Backed Security

Treasury Inflation Protected Securities

Due to the desired weightings of each security and the size of each account, compromises are often made.[13] Further, some investors do not own both taxable and tax favored accounts. Therefore, the advantages vary widely. Vanguard conducted a study in which it was determined that the annual advantage ranged from 0% to .75%, but for our purposes of measuring the total advantage, I will ignore asset location.

Order of Withdrawal Annual Advantage 0% to .70%

Clients who hold multiple account types such as individual, joint, traditional IRA and Roth IRA accounts are faced with a decision in retirement regarding the order of withdrawal. Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of the retirement years, thereby increasing wealth and the longevity of the portfolio. At times it is actually beneficial to increase the current tax, if by so doing a spike in tax brackets in later years can be avoided. Nonetheless, the proper order of withdrawal is usually 1) taxable accounts, 2) tax deferred accounts, 3) tax free accounts. The calculation is muddied by other factors such as the opportunity to convert traditional IRAs to Roth IRAs, the optimal Social Security Retirement claiming strategy based upon life expectancy, the other income such as part-time earned income, tax free municipal bond interest, and other non- earned income such as pensions, and the effect of these various types of income upon “provisional income” and its effect upon Social Security taxation. A calculation which compares the internal rate of return of the optimal spending order to that of the reverse order results in an advantage of up to .70%. Not all retired clients have multiple accounts, nor are all clients in the distribution phase. For those clients, there is no advantage. Therefore for our purposes of measuring the total advantage I will ignore the benefits of optimal order of withdrawal. Summary It is not possible to illustrate a precise advantage of retaining an excellent advisor over a typical one, but a rough average can be determined. To avoid overstating the case, I will exclude any advantage that can only be achieved if both tax-qualified and non-qualified accounts exist. Note that a few investors will be skillful or lucky enough to implement some of these strategies without advice. On the other hand, some will do even worse than the average. The rough average advantage within accounts is as follows:

Expense Ratio

.24%

Rebalancing

.31%

Turnover

.58%

Cash Drag

.12%

Pragmatic Investing

1.40%

Behavioral Coaching

1.49%

Asset Location

0%

Order Of Withdrawal

0%

TOTAL Average Annual Advantage

4.14%

Excellent Advice benefiting clients outside or between accounts

The Implementation of advice for actions outsideof (or between) accounts is the responsibility of the client. Obviously if the advice is not taken, there is no advantage. The advantage of advice that impacts transactions outside of accounts tends to be uneven, with sometimes no advantage over the course of years, with sporadic large advantages taking place at various points in time as a result of advice given. I will give anecdotal examples of this type of advice using reasonable assumptions, and the estimated resulting dollar advantage of each. The supporting calculations are found in the endnotes. Examples:

Advice regarding cash reserves:

Assume that an excellent advisor helps a client to establish a cash reserve target of $50,000 to be held in bank accounts to meet emergencies and opportunities, and that the client has $250,000 in liquid bank accounts. If the advice causes the excess $200,000 to be invested over the next fifteen years for retirement in a 60% stock/40% bond account the terminal before-tax advantage to the client is $312,469.[14]

Advice regarding the payoff of a mortgage:

Assume that a client owes $300,000 on a 30 year first mortgage with an interest rate of 4%, and wishes to pay it off with $300,000 in funds in a 60% stock/40% bond account. If the advice changes the mind of the client and the mortgage is retained, the terminal advantage to the client is $425,511[15].

Advice regarding choice of account type:

Assume that a couple who is in a 39.6% tax bracket will retire in fifteen years and subsequently will be in a 15% tax bracket through their retirement years.[16] Each spouse plans on contributing $6,500 per year to a 60% stock/40% bond Roth IRA until retirement, and then to liquidate the holdings and withdraw the funds. If the advice given leads the couple to select a traditional IRA instead of a Roth IRA, the total after-tax advantage at retirement is $72,883.

Advice regarding Roth 401k Conversion

Assume that an ambitious 30 year-old business executive has a $45,000 401k and plans on leaving it invested in a 60% stock/40% bond mix until retirement at age 65, at which time the funds will be withdrawn. Assume that the client’s earnings will increase over the years, and that his current 15% tax bracket will increase to a 39.6% bracket and remain at that bracket through his retirement.[17] If the advice causes the client to convert his traditional 401k to the Roth 401k option, his after tax advantage at retirement is $103,669.[18]

Advice regarding Recharacterization of a Roth IRA Conversion

Assume that in January a client in a 39.6% tax bracket converts $500,000 from a traditional IRA to a new Roth IRA,[19] and that after a 20 month long bear market, the Roth IRA has dropped in value to only $350,000. If advice causes the client to recharacterize the funds and convert again one month later at the recharacterization value, the immediate tax savings to the client is $59,400.

Advice concerning company stock

Assume that a client in a 39.6% tax bracket is retiring and owns a $1 million 401k consisting of company stock with a basis of $200,000. If our advice causes him to pay long term capital gains on the net unrealized appreciation and roll the basis into an IRA,[20] instead of rolling the entire 401k to an IRA, the tax savings are $156,800.[21]

Advice regarding life insurance coverage

Assume that through our insurance evaluation we determine that a 55-year-old client who pays $320 per month for a $1 million ten-year level term life insurance policy is self-insured. If our advice causes him to cancel the policy, the future value of the savings if invested into a 60% stock/40% bond portfolio for ten years is $54,482.[22]

Advice regarding a deferred annuity

Assume that a client owns a $700,000 deferred annuity invested in subaccounts weighted 60% stock/40% bond, a surrender charge of 5%, and total annual costs are 3.5%. If our advice causes the client to pay the penalty by 1035 exchanging the annuity into a fee-only annuity with the same investment mix, but total costs of 1.5%, the twenty year future value savings is $609,795.

Advice regarding long term care insurance

Assume that a 65 year-old widow owns a long term care policy with an annual premium of $9,000 and a maximum benefit of $500,000.[23] If an analysis shows that the client is self- insured, and could afford the costs of long term care through the sale of assets, and at age 90 she is admitted into a nursing home and over the course of five years the total cost for care is $500,000, the terminal advantage to the client if the policy is cancelled is $37,588.[24]

Advice regarding equity exposure

Assume that a young and inexperienced client will contribute $25,000 per year for thirty years, is fearful of equity investing, and plans on investing strictly into guaranteed bonds.[25] If educational efforts cause the client to invest into a 60% stock/40% bond account, the terminal before-tax advantage to the client is $581,818.

Advice regarding charitable gifts

Assume that a client in a 39.6% tax bracket who owns $200,000 of stock with a basis of $40,000 gives $10,000 per year in cash to a charity for 20 years, then sells the stock. If advice causes the client to gift $10,000 per year in stock instead of the cash, the capital gains tax savings is $32,000. [26]

Advice regarding estate tax

Assume that a wealthy elderly couple resides in Washington State without credit bypass trusts and have a combined taxable estate of $12 million. If advice causes the couple to have an attorney include credit bypass trusts in their wills or draft a portability election return, the tentative estate tax savings are $2,748,576.

Advice regarding the ownership of life insurance

Assume that a wealthy Washington State widow with a $40 million estate plans to provide for her grandchildren by purchasing a $10 million Variable Universal Life policy, with herself as owner and insured, and each of her ten grandchildren as equal beneficiaries. She makes premiums of $140,000 per year. If advice causes her to create an irrevocable life insurance trust to own the policy instead, the tentative estate tax savings is $5,200,000.[27]

Advice regarding Social Security Retirement Benefits

Assume that a couple, both age 62, plan on taking their Social Security Benefits now. The husband is slated to receive a benefit of $1,878 per month, and the wife will receive $1,603. Based upon family history and health, we assume both expect to live to age 90. If advice causes the couple to change the strategy to have the husband file and suspend benefits at full retirement age, which allows the wife to take a restricted spousal benefit at that time, and then at age 70 have the husband begin his own benefit, and to have the wife switch to her own benefit, the total additional lifetime benefits received is $746,333. &nbsp;

Advice regarding a change in risk tolerance

Assume that a client who invests a $1 million account in a 60% stock/40% bond portfolio suffers a loss of market value of $300,000 in a severe bear market, and decides to liquidate the equity investments at a loss and move into guaranteed bonds. If behavioral coaching motivates the client to stay the course, the advantage in market value by the end of five years over the average five year historical period is $152,080.[28]

Summary

Although these savings vary widely, it is apparent that they are significant and likely to make a large difference in total wealth to many clients over a lifetime of investing. When they are added to the estimated ongoing annual advantage of 4.14% over typical advice, and when the average advisory fee of an excellent advisor is in the range of 1% per year, it is clear that the total advantage gained through a relationship with an excellent advisor far exceeds both the amount paid and the results that are obtained through a typical advisor or as the result of self-advice. Click Here to See the Quantifying Value Calculations &nbsp; Footnotes [1] The advantages are based upon historical data. Accurate data for some advantages is not available for time frames of sufficient length to result in a high degree of confidence. It should not be assumed that future data will always be similar to past data. Therefore there is no guarantee that all past advantages will persist; however probable they may be. [2] Pragmatic stock funds defined as core equity funds with 56% in domestic, 23% in international, 10% in emerging, and 11% in real estate security open ended mutual funds, using DFA as the proxy. [3] A blended account will be defined as a 60% stock/40% bond account. We will assume annually compounded total returns on stocks before cost to be 10%, which is similar to the CRSP database historical gross return from 1926 through 2013 of 9.9%. We will assume annual advisory costs to be 1%, resulting in total returns after cost to be 9%. We will assume annually compounded total returns before cost on bonds and cash to be 4%, which is significantly lower than the return on long term government bonds from 1926 through 2013 of 5.5% and long term corporate bonds of 6%, and similar to the historical returns on one month treasury bills from 1926 through 2013 of 3.5%. After costs the assumed rate of return on bonds and cash is 3%. The blended account overall is assumed to have a total average annually compounded after cost return of 6.6%. This is not meant to be promissory, but rather to be illustrative of the average historical blended account. Actual returns will vary and could be significantly different than the illustrated returns. [4] For an excellent advisor, low expense ratios are an important factor in security selection, but they are not the only factor. Some items are worth paying for, and as a result the funds selected by an excellent advisor are not always the least expensive. [5] 53 years is not a sufficient time period to result in a high degree of confidence [6] As measured by standard deviation [7] Bogle on Mutual Funds, 1993 [8] According to Comcast Data in their report titled Mutual Fund Cash Levels, June 16, 2013. Average Mutual fund cash levels from 1968 through May of 2013 were considerably higher, with levels averaging approximately 7% in the 1970s, 9% in the 1980s,and 7% in the decade beginning in the year 2000. [9] In today’s low interest rate environment when cash is earning close to 0%, the actual advantage is .18% [10] Active management has the goal of maximizing returns by predicting the future price of securities and markets. Passive management has the goal of obtaining index returns less costs. Pragmatic investing has the goal of maximizing risk-adjusted returns using the academic research of Eugene Fama and Kenneth French including the efficient market hypothesis and the three factor model. [11] Dimensional Matrix Book 2014 [12] Note that this difference between mutual fund returns and the returns of fund investors does not capture the full advantage. The aforementioned numbers reflect only the inferior returns of average investors while they are invested in the funds, due to their poor timing of deposits and withdrawals. They do not reflect the poor returns they likely receive during the periods of time when they are not invested. Since mutual fund outflows typically increase after market downturns, we can see that a common motivation for withdrawals is fear. A fearful investor is likely to redeploy the withdrawn funds into cash, bonds, or bond funds. However, some of these funds are invested into other stock funds, and we have no way of measuring what portion of the total this is. Intuition would lead us to believe that the largest portion of these funds are not reinvested into the stock market, and as a result, the average investor suffers a large opportunity cost. [13] Further, liquidity needs can trump tax efficiency. For example, an account that will be subject to withdrawals within a few short years may appropriately be invested into fixed income securities rather than tax efficient equity funds, regardless of the tax consequences. In certain situations, tax free municipal bonds can satisfy the need for both liquidity and tax efficiency. [14] Assumptions: bank account interest rate .3%; average historical after-cost 60% stock/40% bond account returns: 6.6% [15] Assumptions: average historical after-cost equity returns 9%, after-cost bond returns 3%. [16] All traditional IRA contributions are assumed to be deducted in the 33% tax bracket; all traditional IRA withdrawals are assumed to be taxed in the 15% bracket. No accounting is made for the time value of money after the retirement date. [17] The entire conversion is assumed to be taxed in the 15% tax bracket, and is assumed to come from the IRA funds. If the tax were paid from a non- qualified account, the advantage would be greater. [18] This does not include the added benefit of additional contributions to the Roth 401k in brackets below 40%. [19] The entire converted amount is assumed to be taxed in the 39.6% tax bracket. Account value assumed to unchanged during the mandatory 30-day waiting period after recharacterization. [20] NUA technique, reference Putnam Understanding the NUA rule, and Robert Keebler. The basis in company stock is assumed to be rolled into a traditional IRA within 60 days, and the shares attributable to net unrealized appreciation are assumed to be taken “in kind”, deposited into a taxable account, and sold immediately. [21] The new IRA need not be liquidated; as in all IRAs, tax is assessed only upon withdrawals. Nor do the NUA shares need to be liquidated; gains on any shares sold within one year will be assessed tax at the short term capital gains rate to the extent the gains occurred after the 401k distribution. All gain on shares liquidated immediately or held for more than one year will be treated as long term capital gain. [22] If premature death were to occur during the term, the life insurance death benefit would cause a large advantage to the beneficiaries. However, if the insurance is not needed, the death benefit would not accomplish any financial goals, whereas if the insurance is cancelled the funds that otherwise were lost to premiums can be invested and used to accomplish important goals such as achieving a comfortable retirement. Also consider that in order for insurance companies to be profitable, on average; premiums paid for insurance must exceed benefits. [23] No COLA; assuming premiums are invested into a 60% stock/40% bond account [24] If the assumed growth rate in the terminal value of the account is accounted for during the five years of long term care, the advantage is larger. Also, if no long term care need arises, the advantage is $537,588. On the other hand, if a long term care need arises in the early years, the insurance carries a sizeable advantage. [25] Assuming a 3% rate of interest, all interest reinvested [26] Assuming no further appreciation in stock price. [27] Assuming that gifts under the annual exclusion are made for each beneficiary each year with Crummey Powers. [28] Every five year period is different, but this is the average result